The inequitable mortgage interest tax deduction

Catherine Rampell on her blog today highlights data on the increasing size of American houses. The data from the U.S. Census Bureau show how the floor size of the median home and the number of bedrooms in homes have been increasing over time. Rampell uses the data to point out that the housing crash hasn’t killed “McMansions,” speculating instead that the trend continues because higher income households can afford homes currently and these households buy bigger homes.

But the McMansion trend predates the housing bubble, the housing crash, and the Great Recession. So why is the size of American homes increasing? Some of the increase may be due to the increasing wealth of those at the top of the income and wealth ladder over the past several decades, but there’s strong evidence that public policy helped spur Americans to buy bigger homes—in particular the mortgage interest tax deduction.

This tax deduction enables homeowners to deduct the interest they pay on their mortgages on their tax returns for loans up to a $1 million and deductions are limited for individual earners making more than $400,000 and couples making more than $450,000. At first glance, the policy sounds reasonable. But by reducing pre-tax income and relying on taxpayers to take up the policy themselves, the deduction primarily benefits a subset of higher-income taxpayers, or those earning between the 90th and 95th percentile of the income distribution.

The deduction gets pitched as an effort to increase homeownership, but academic research finds that really it just increases the size of homes purchased. One study by economist Andrew Hanson at Marquette University demonstrates that the deduction is responsible for an increase of between 10 and 18 percent in the size of the home purchased. Yet the deduction has no effect on homeownership, as it doesn’t increase the financial incentives enough. In a paper on reforming the deduction, economist Eric Toder and others at the Tax Policy Center look at the research on the whole and say the research “has found little evidence that the [deduction] increases homeownership.”

In economics jargon, the home mortgage interest deduction incentive works on the intensive, not the extensive, margin. In plain English, current tax policy doesn’t get more people to buy homes (the extensive), it gets people to buy more home (the intensive).

Imagine trying to convince the public that a tax deduction that primarily reduces the tax burden of the some of the richest households and encourages them to buy bigger homes is a good idea.

The many problems with the mortgage interest deduction are well known to economists and policy makers. And calls for the reform or even elimination of the deduction are frequent. But it’s worth a reminder of how inequitable and ineffective at its stated goal the policy is.